Why I’m Building A Position In Cannabis Multi-State Operators (NYSEARCA:MSOS)

Cannabis shop logo and sign on Cannabis store in a city.

Olga PS/iStock via Getty Images

In today’s article I’d like to explain why I’ve begun accumulating a position in Cannabis multi-state operator companies. I’ll also explain why I’m using the AdvisorShares Pure US Cannabis ETF (NYSEARCA:MSOS) to accomplish this.

What are Cannabis Multi-State Operators?

Cannabis multi-state operators exist in their current form because — while cannabis is legal in some states, each with their own set of rules — cannabis has not yet been made legal at the Federal level. This latter fact has several repercussions, including prohibiting interstate trade of cannabis (and creating a lack of banking options as I’ll discuss below). This means that cannabis products sold in any given state must also be grown, processed and packaged in that state.

Multi-state operators typically set up multiple subsidiaries, one per state they wish to operate in, with each one being configured to adhere to a given state’s laws. There is some leverage in learning from operations in each state, as well as sharing branding and marketing, but because of the lack of interstate commerce and the idiosyncrasies of each market, there are also many aspects to each company that are duplicative from state to state.

Why Use An ETF?

The fact that the sale of cannabis is still not legal federally also means that MSOs can’t list on US national exchanges [note that I will use the abbreviation MSOs to denote multi state operators while I’ll use all caps when discussing the symbol of the ETF]. Most MSOs are listed on Canadian exchanges and trade as over the counter tickers in the US. Trading these names individually is thus a little more cumbersome than trading US-listed stocks, but it’s definitely doable and it allows one the opportunity to take advantage of moves in the individual names. For me personally that benefit is outweighed by the lack of options availability in the OTC names, so I’ve decided to use MSOS, which has weekly options, as my vehicle to hold and trade this sector. (I should mention that MSOS holds its stocks via swaps, so that is an additional risk to taking this approach.)

Note also that there are US-listed cannabis companies, but because of Federal laws, these operate outside of the US. I briefly review these a few sections down.

MSOS Holdings

This is the MSOS ETF holding page from which I excerpt its top 10 holdings. I will use the top 6 of these later when I look at the valuation for the sector.

advisorshares.com/etfs/msos/

MSOS holdings

Investment Thesis

1. Big Picture

I believe that cannabis is a relatively safe drug and that its consumption is actually safer than that of alcohol. Owing to my age and generation, I’m a social drinker and not a cannabis user, but as I survey those younger than me, I see a definite trend of a greater tendency to use cannabis relative to alcohol the younger one is. Thus I believe there is a generational shift in place that should yield long term investment returns.

Despite the many limitations currently being placed on MSOs I believe that there will be a significant first mover advantage due to:

  • having early experience in the market and learning what works and doesn’t work in catering to customers in this new market,
  • establishing brands and brand packaging,
  • learning the ins and outs of cannabis production and processing,
  • having state licenses in place, as these will likely still be necessary if/when cannabis becomes federally legal,
  • and similarly having experience in the regulatory and tax regimes that will still exist to a large extent once federal prohibitions are lifted.

Thus my overarching investment thesis is very long term and I intend to play it that way; though I’ll have some shares carved out to trade dips and spikes in the market.

2. MSOs vs Listed Names Operating Outside of the US

To understand why I’ve decided to focus on MSOs and not US-listed cannabis stocks that operate outside of the US, first review my bullet list above as those factors apply mainly to companies operating in the US.

Then consider that the stock price for MSOs has really fallen recently, as can be seen by the chart below:

Chart
Data by YCharts

Finally, consider a sample of the larger US-listed stocks (Canopy Growth (CGC), Tilray Brands (TLRY), & Aurora Cannabis (ACB)). In my opinion, their valuation, growth rates and profitability measures are substantially less attractive than those of the MSOs. In the graphics below, I’ve highlighted what I consider to be the most important metrics in each category, these can be compared to a set of MSOs which I’ve included in a later section of this article. After reviewing these, I think most readers will agree that MSOs currently sport better metrics than the US-listed companies.

seekingalpha.com/comparison/95b9914375-Canadian-Cannabis

Seeking Alpha

Growth Rates

Seeking Alpha

Profitability

Seeking Alpha

3. Sentiment

Two years ago, seemingly everyone was talking about cannabis stocks and how they’d soon get rich from them. Slowly reality has set in and as the stocks’ prices have fallen relentlessly, sentiment has completely reversed to where the majority of people don’t even want to hear about these stocks anymore. To me that marks a good long term entry point, especially if one has the intention of accumulating shares over time, i.e. one isn’t trying to pick an exact bottom.

One data set to corroborate my impression regarding sentiment comes from a site that tracks the WallStreetBets reddit site. Here’s a graphic display of its tallying of WSBs mentions:

MSOS WSB sentiment

swaggystocks.com

It would be hard to have a more stark chart to make this point, but at the same time, there’s no indication that sentiment has bottomed, so anyone looking to join me in this investment might want to space buys over several months or even years.

4. Valuation

Despite the complications of having subsidiaries for each state in which they operate, MSOs are profitable on an EBITDA basis and many have positive net income margins. EV to sales ratios are reasonable as well. Revenue growth rates are high, but partly due to acquisitions, i.e. not due exclusively to organic growth. Perhaps more importantly, forward one year EBITDA growth rates range from 33% to 60%!

Thus even without all of the positives that might accrue from legal changes, MSOs represent reasonable buys at current prices and under current laws.

valuation

Seeking Alpha

Growth rates

Seeking Alpha

Profitability

Seeking Alpha

5. Structural Factors / Catalysts

I, and most sector analysts I think, believe that eventually cannabis will become legal federally. I personally think it will take a few years, but when it happens, or even if it happens in some staged manner, the following big structural changes should acts as bullish catalysts for the MSOs:

5.1 Banking

When the sale of cannabis is legal federally, MSOs will be able to use large banks much as every other type of company can. Crucially this will allow access to short and long term loans and lines of credit at much more competitive rates and for substantially larger amounts than currently available. Perhaps as importantly, it will allow use of more credit card payments and should eliminate many of the burdens that arise from what is now a quasi-cash business (at the retail level).

These banking benefits may also obtain in a staged manner, for example if the much ballyhooed SAFE Banking Act were to pass. Since passage of this Act could be a huge catalyst for the sector, here are a few excerpts taken from its sponsor’s web page (see the bottom of that page for an impressive list of supporters):

[T]he SAFE Banking Act of 2021 seeks to harmonize federal and state law by prohibiting federal regulators from taking punitive measures against depository institutions that provide banking services to legitimate cannabis-related businesses and ancillary businesses (e.g. electricians, plumbers, landlords, etc.) that serve them. The bill establishes a safe harbor for any depository institution that chooses to provide banking services to a cannabis-related legitimate businesses which holds and maintains a license from a state or local government to engage in manufacturing, growing, or producing, as well as any business who handles, sells, transports, displays or distributes cannabis or cannabis products.

[…]

To date, the SAFE Banking Act has passed the U.S. House six times, most recently in February 2022 as an amendment to the America COMPETES Act. Previously, the SAFE Banking Act, as a standalone bill, passed the House by a vote of 321 to 101 on April 19, 2021, with 106 Republicans voting in support. In February 2019, the SAFE Banking Act prompted the first-ever congressional hearing on the issue of cannabis banking. Click here to see the 2019 report from the House Financial Services Committee. Changes in the 117th Congress include minor technical changes to the safe harbor, strengthened hemp provisions, and other technical updates. Perlmutter first introduced a similar version of the SAFE Banking Act in July 2013.

5.2 Homogenization & Efficiency

When interstate commerce is allowed, all of these companies will be able to centralize and homogenize product sourcing, blending and processing. This will lead to the product of any given brand being essentially the same no matter what state it’s sold in. From a cost and consumer experience this will have a dramatically positive effect.

Centralization will also allow all back office operations to be much more efficient and these gains should also drop directly to the various companies’ bottom lines.

5.3 Uplisting

Once the sale of cannabis becomes legal federally, most if not all of the MSOs will seek to uplist to major US Exchanges like the NYSE and NASDAQ. This will make trading these stocks much less cumbersome and will also allow options to be listed against the larger names. All of this on its own should greatly boost demand for these stocks.

5.4 Opens Ownership to a Whole New Group of Potential Investors

More important than the uplisting itself will be the increase in the pool of investors who can own these stocks. Currently many pension funds and institutions are wary and/or prohibited by charter from investing in companies whose activities aren’t legal on the Federal level.

Legalization will bring in a host of new demand and this may be the biggest (and most bullish) sea change the sector will ever undergo.

Options

As I mentioned previously, MSOS trades options. The volumes aren’t huge, but for smaller investors like myself, they’re liquid enough. Here are snapshots of the nearest weekly and monthly call quotes to get a sense of volume, open interest and implied volatilities:

weekly options

www.barchart.com

Monthly options

www.barchart.com

Risks

The biggest risks in investing in the sector in my opinion are:

  1. That sentiment hasn’t bottomed. I.e. there may still be many people who bought in to cannabis stocks as “get rich quick schemes” who still haven’t disgorged their stocks when those dreams proved unfounded. Though I’m buying now, a more prudent approach may be to wait for sentiment not only to bottom but to show evidence of a solid uptick.
  2. Similarly, many people are investing on the idea that legal changes will happen in the very near term. Should that not come to pass (and as I said above, I believe eventually the changes will come, but not as quickly as many think/hope), then these disappointed shareholders may become sellers.
  3. States look at the MSOs as generating tax windfalls and current state taxes (which are applied along the entire value chain) may be unsustainable, particularly in light of vibrant black market activity. If states don’t modify their tax rates and approaches, they may end up killing these companies, at least in some states. This may be the single biggest risk to keep an eye on.

Appendix – Further Reading

For a deeper understanding of the MSOs, here are links to what I consider the best or most helpful recent Seeking Alpha articles on the top five companies in MSOS’ holdings:

Green Thumb (OTCQX:GTBIF)

Trulieve Cannabis (OTCQX:TCNNF)

Curaleaf Holdings (OTCPK:CURLF)

Verano Holdings (OTCQX:VRNOF)

Cresco Labs (OTCQX:CRLBF)


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